Banks Face Pushback Making CLOs Volcker Compliant

Banks that want to keep their holdings of collateralized loan obligations will likely face an uphill battle getting these investments in compliance with the Volcker Rule, according to Wells Fargo.

The final version of the rule, released Dec. 10, prohibits banks from holding a securitization backed by anything other than loans. And most CLOs have significant holdings of bonds and other kinds of securities, in addition to corporate loans.

Various trade groups have been lobbying for a fix for CLOs that invest in bonds, but regulators have yet to respond. That leaves banks wondering whether they will have to unload their holdings, which total as much as $70 billion, before the rule takes effect in 2015.

Analysts at Wells Fargo expect banks to attempt, on a deal-by-deal basis, to work with managers to remove bonds from CLO asset portfolios. However, the analyst expect CLO equity holders to push back on this, as bonds can provide value to equity tranche owners, especially during times of volatility, and as assets to purchase just prior to the reinvestment period conclusion.

Equity holders may even look to take punitive action against managers that empty their bond buckets, depending on how managers assure senior holders, the analysts stated in a report published today.

Another option for making CLOs Volcker compliant is to address the rights of senior note holders. Holding debt does not usually confer ownership rights, but holders of the senior notes issued by CLOs have the ability to remove the deal’s manager for cause. This has raised concerns that senior note holders will be considered to hold ownership interests in the deal under the Volcker Rule. And bank holdings are concentrated in these senior notes.

Wells Fargo analysts see a possible work around: including these existing manager removal clauses as events of default, albeit with less punitive remedies. “After all, equity and mezzanine note investors would not want a deal to enter acceleration just because a portfolio manager leaves the firm,” they stated in the report.

If the 2015 deadline for compliance approaches with no clarity, however, banks may be forced to waive manager removal rights as a last resort.

A lack of clarity on the Volcker Rule has pushed AAA spreads slightly wider, and new issuance has been slowed. “Although new deals will have mechanisms for Volcker-compliance, many investors are waiting for clarity,” the analysts stated. “Investors fear buying in the primary, only to have an adverse ruling push secondary spreads meaningfully wider.”

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